Book Description
Practical tools and advice for managing financial risk, updated for a postcrisis world
Advanced Financial Risk Management bridges the gap between the idealized assumptions used for risk valuation and the realities that must be reflected in management actions. It explains, in detailed yet easytounderstand terms, the analytics of these issues from A to Z, and lays out a comprehensive strategy for risk management measurement, objectives, and hedging techniques that apply to all types of institutions. Written by experienced risk managers, the book covers everything from the basics of present value, forward rates, and interest rate compounding to the wide variety of alternative term structure models.
Revised and updated with lessons from the 20072010 financial crisis, Advanced Financial Risk Management outlines a framework for fully integrated risk management. Credit risk, market risk, asset and liability management, and performance measurement have historically been thought of as separate disciplines, but recent developments in financial theory and computer science now allow these views of risk to be analyzed on a more integrated basis. The book presents a performance measurement approach that goes far beyond traditional capital allocation techniques to measure riskadjusted shareholder value creation, and supplements this strategic view of integrated risk with stepbystep tools and techniques for constructing a risk management system that achieves these objectives.
Practical tools for managing risk in the financial world
Updated to include the most recent events that have influenced risk management
Topics covered include the basics of present value, forward rates, and interest rate compounding; American vs. European fixed income options; default probability models; prepayment models; mortality models; and alternatives to the Vasicek model
Comprehensive and indepth, Advanced Financial Risk Management is an essential resource for anyone working in the financial field.
Table of Contents
 Cover
 Contents
 Title
 Copyright
 Dedication
 Introduction: Wall Street Lessons from Bubbles

Part One: Risk Management: Definitions and Objectives

Chapter 1: A Risk Management Synthesis
 Risk Management: Definitions and Objectives
 Advances in Integrated Risk Management and Institutional Barriers to Progress
 Measuring the TradeOffs between Risk and Return
 When Bad Things Happen to Good People
 U.S. Savings and Loan Crisis
 LongTerm Capital Management
 The 2006–2011 Credit Crisis
 A Thousand Cuts
 Notes

Chapter 2: Risk, Return, Performance Measurement, and Capital Regulation
 Practical Quantification of Risk
 Perils and Pitfalls in the Measurement of Risk: The Impact of Selection Bias
 Biases in Return vs. a Relative Benchmark
 Historical Value at Risk: Selection Bias Again
 Monte Carlo–Based Value at Risk
 Expected Losses on Tranches of Collateralized Debt Obligations
 Measuring Return: Market vs. Accounting Returns
 Introduction to Transfer Pricing: Extracting Interest Rate Risk in a Financial Accounting Context
 Performance Measurement and Capital Regulation
 Perspectives on Measuring Risk: One Source of Risk or Many Sources of Risk?
 Interest Rate Risk Management Evolution
 Equity Risk Management Evolution
 Option Risk Management Evolution
 Credit Risk Management Evolution
 Managing Risk and Strategy, Business by Business
 Risk and Strategy Management in a Complex Financial Institution
 What Causes Financial Institutions to Fail?
 The Role of Capital in Risk Management and Business Strategy
 CapitalBased Risk Management in Banking Today: Pros and Cons
 History of CapitalBased Regulations in Commercial Banking
 Notes

Chapter 1: A Risk Management Synthesis

Part Two: Risk Management Techniques for Interest Rate Analytics
 Chapter 3: Interest Rate Risk Introduction and Overview

Chapter 4: Fixed Income Mathematics
 Modern Implications of Present Value
 Price, Accrued Interest, and Value
 Calculation of Accrued Interest
 Present Value
 The Basic Present Value Calculation
 Calculating the Value of a Fixed Coupon Bond with Principal Paid at Maturity
 Calculating the Coupon of a Fixed Coupon Bond with Principal Paid at Maturity When the Value Is Known
 The Value of an Amortizing Loan
 Calculating the Payment Amount of an Amortizing Bond When the Value Is Known
 Calculating the Value of a FloatingRate Bond or Loan with Principal Paid at Maturity
 Compound Interest Conventions and Formulas
 Compounding Formulas and Present Value Factors P(t)
 Yields and YieldtoMaturity Calculations
 The Formula for Yield to Maturity
 Yield to Maturity for Long or Short First Coupon Payment Periods
 Calculating Forward Interest Rates and Bond Prices
 Implied Forward Interest Rates on ZeroCoupon Bonds
 Implied Forward ZeroCoupon Bond Prices
 Present Value of Forward Fixed Coupon Bond
 Implied Forward Price on a Fixed Coupon Bond
 Implied Forward Coupon on a Fixed Coupon Bond
 Other Forward Calculations
 Summary
 Notes

Chapter 5: Yield Curve Smoothing
 Example A: Stepwise Constant Yields and Forwards vs. NelsonSiegel
 Deriving the Form of the Yield Curve Implied by Example A
 Fitting the NelsonSiegel Approach to Sample Data
 Example D: Quadratic Yield Splines and Related Forward Rates
 Deriving the Form of the Yield Curve Implied by Example D
 Example F: Cubic Yield Splines and Related Forwards
 Deriving the Form of the Yield Curve Implied by Example F Assumptions
 Example H: Maximum Smoothness Forward Rates and Related Yields
 Deriving the Parameters of the Quartic Forward Rate Curves Implied by Example H Assumptions
 Comparing Yield Curve and Forward Rate Smoothing Techniques
 Trading Off Smoothness vs. the Length of the Forward Rate Curve
 The Shimko Test for Measuring Accuracy of Smoothing Techniques
 Smoothing Yield Curves Using CouponBearing Bond Prices as Inputs
 Appendix: Proof of the Maximum Smoothness Forward Rate Theorem
 Notes

Chapter 6: Introduction to Heath, Jarrow, and Morton Interest Rate Modeling
 Objectives of the Example and Key Input Data
 Key Implications and Notation of the HJM Approach
 PseudoProbabilities
 The Formula for ZeroCoupon Bond Price Shifts
 Building the Bushy Tree for ZeroCoupon Bonds Maturing at Time T = 2
 Building the Bushy Tree for ZeroCoupon Bonds Maturing at Time T = 4
 Valuation in the HJM Framework
 Valuation of a ZeroCoupon Bond Maturing at Time T = 4
 Valuation of a CouponBearing Bond Paying Annual Interest
 Valuation of a Digital Option on the OneYear U.S. Treasury Rate
 Conclusion

Chapter 7: HJM Interest Rate Modeling with Rate and MaturityDependent Volatility
 Objectives of the Example and Key Input Data
 Key Implications and Notation of the HJM Approach
 PseudoProbabilities
 The Formula for ZeroCoupon Bond Price Shifts
 Building the Bushy Tree for ZeroCoupon Bonds Maturing at Time T = 2
 Building the Bushy Tree for ZeroCoupon Bonds Maturing at Time T = 4
 Valuation in the HJM Framework
 Valuation of a ZeroCoupon Bond Maturing at Time T = 4
 Valuation of a CouponBearing Bond Paying Annual Interest
 Valuation of a Digital Option on the OneYear U.S. Treasury Rate
 Conclusion

Chapter 8: HJM Interest Rate Modeling with Two Risk Factors
 Probability of Yield Curve Twists in the U.S. Treasury Market
 Objectives of the Example and Key Input Data
 Introducing a Second Risk Factor Driving Interest Rates
 Key Implications and Notation of the HJM Approach
 PseudoProbabilities
 Valuation in the HJM Framework
 Valuation of a ZeroCoupon Bond Maturing at Time T = 4
 Valuation of a CouponBearing Bond Paying Annual Interest
 Valuation of a Digital Option on the OneYear U.S. Treasury Rate
 Replication of HJM Example 3 in Common Spreadsheet Software
 Conclusion

Chapter 9: HJM Interest Rate Modeling with Three Risk Factors
 Probability of Yield Curve Twists in the U.S. Treasury Market
 Objectives of the Example and Key Input Data
 Risk Factor 1: Annual Changes in the OneYear U.S. Treasury Spot Rate
 Alternative Specifications of the Interest Rate Volatility Surface
 Key Implications and Notation of the HJM Approach
 PseudoProbabilities
 Valuation in the HJM Framework
 Valuation of a ZeroCoupon Bond Maturing at Time T = 4
 Valuation of a CouponBearing Bond Paying Annual Interest
 Valuation of a Digital Option on the OneYear U.S. Treasury Rate
 Conclusion
 Note

Chapter 10: Valuation, Liquidity, and Net Income
 How Many Risk Factors are Necessary to Accurately Model Movements in the RiskFree Yield Curve?
 Revisiting the Phrase “No Arbitrage”
 Valuation, Liquidity Risk, and Net Income
 RiskNeutral and Empirical Probabilities of Interest Rate Movements
 Monte Carlo Simulation Using HJM Modeling
 Common Pitfalls in Interest Rate Risk Management
 Summarizing the Problems with Interpolated Monte Carlo Simulation for Risk Analysis
 Notes
 Chapter 11: Interest Rate Mismatching and Hedging

Chapter 12: Legacy Approaches to Interest Rate Risk Management
 Gap Analysis and Simulation Models
 Measuring Interest Rate Risk: A Review
 Legacy Rate Risk Tools: Interest Rate Sensitivity Gap Analysis
 The Safety Zone
 What’s Wrong with Gap Analysis?
 Legacy Rate Risk Tools: Multiperiod Simulation
 Modeling the Maturity Structure of a Class of Assets
 Macaulay’s Duration: The Original Formula
 Using Duration for Hedging
 Comparing a Duration Hedge with Hedging in the HJM Framework
 Duration: The Traditional Market Convention
 The Perfect Duration Hedge: The Difference between the Original Macaulay and Conventional Durations
 Convexity and Its Uses
 Conclusion
 Note

Chapter 13: Special Cases of Heath, Jarrow, and Morton Interest Rate Modeling
 What is an Academic Term Structure Model and Why Was It Developed?
 The Vocabulary of Term Structure Models
 Ito’s Lemma
 Ito’s Lemma for More Than One Random Variable
 Using Ito’s Lemma to Build a Term Structure Model
 Duration as a Term Structure Model
 Conclusions about the Use of Duration’s Parallel Shift Assumptions
 The Vasicek and Extended Vasicek Models
 The Merton Term Structure Model: Parallel Yield Curve Shifts
 The Extended Merton Model
 The Vasicek Model
 The Extended Vasicek–Hull and White Model
 Alternative Term Structure Models
 Reprising the HJM Approach
 Appendix A: Deriving ZeroCoupon Bond Prices in the Extended Merton/Ho and Lee Model
 Appendix B: Deriving ZeroCoupon Bond Prices in the Vasicek Model
 Appendix C: Valuing ZeroCoupon Bonds in the Extended Vasicek Model
 Notes
 Chapter 14: Estimating the Parameters of Interest Rate Models

Part Three: Risk Management Techniques for Credit Risk Analytics

Chapter 15: An Introduction to Credit Risk
 Market Prices for Credit Risk
 Critical Sources of Market Data on Credit Risk
 Increased Accuracy in Pricing
 Increased Clarity in Corporate Strategy
 Increased Sophistication in Risk Management
 Increased Precision in Measuring the Safety and Soundness of Financial Institutions
 Credit Default Swaps: The Dangers of Market Manipulation
 Daily Nondealer Trading Volume for 1,090 Reference Names
 Credit Default Swap Trading Volume in Municipals and SubSovereigns
 Credit Default Swap Trading Volume in Sovereign Credits
 Implications of CDS Trading Volume Data
 Notes

Chapter 16: Reduced Form Credit Models and Credit Model Testing
 The JarrowTurnbull Model
 The Jarrow Model
 ZeroCoupon Bond Prices in the Jarrow Model
 Fitting the Jarrow Model to Bond Prices, Credit Derivatives Prices, and Historical Default Databases
 Correlations in Default Probabilities
 The Jarrow and JarrowTurnbull Models: A Summary
 Tests of Credit Models Using Historical Data
 An Introduction to Credit Model Testing
 Misunderstandings about Credit Model Testing
 The Two Components of Credit Model Performance
 The Predictive Capability of the JarrowChava Reduced Form Model Default Probabilities
 Reduced Form Model vs. Merton Model Performance
 Consistency of Estimated and Actual Defaults
 Recent Results from North America
 The Falkenstein and Boral Test
 Performance of Credit Models vs. Naïve Models of Risk
 Testing Credit Models: The Analogy with Interest Rates
 Appendix: Converting Default Intensities to Discrete Default Probabilities
 Notes

Chapter 17: Credit Spread Fitting and Modeling
 Introduction to Credit Spread Smoothing
 The Market Convention for Credit Spreads
 A Better Convention for Credit Model–Independent Credit Spreads
 Credit Spread Smoothing Using Yield Curve–Smoothing Techniques
 Fitting Credit Spreads with Cubic Splines
 Maximum Smoothness Forward Credit Spreads
 Comparing Results
 Data Problems with Risky Issuers
 Determinants of Credit Spread Levels
 The Credit Risk Premium: The Supply and Demand for Credit
 Conclusion
 Notes

Chapter 18: Legacy Approaches to Credit Risk
 The Rise and Fall of Legacy Ratings
 Ratings: What They Do and Don’t Do
 Through the Cycle vs. Point in Time, a Distinction without a Difference
 Stress Testing, Legacy Ratings, and Transition Matrices
 Transition Matrices: Analyzing the Random Changes in Ratings from One Level to Another
 Moral Hazard in “SelfAssessment” of Ratings Accuracy by Legacy Rating Agencies
 Comparing the Accuracy of Ratings and Reduced Form Default Probabilities
 Problems with Legacy Ratings in the 2006 to 2011 Credit Crisis
 The JarrowMerton Put Option and Legacy Ratings
 The Merton Model of Risky Debt
 The Intuition of the Merton Model
 The Basic Merton Model
 Valuing Multipayment Bonds with the Merton Model of Risky Debt
 Estimating the Probability of Default in the Merton Model
 Implying the Value of Company Assets and Their Return Volatility σ
 Mapping the Theoretical Merton Default Probabilities to Actual Defaults
 The Merton Model When Interest Rates are Random
 The Merton Model with Early Default
 Loss Given Default in the Merton Model
 Copulas and Correlation between the Events of Default of Two Companies
 Problems with the Merton Model: Summing Up
 Appendix
 Notes

Chapter 19: Valuing Credit Risky Bonds
 The Present Value Formula
 Valuing Bonds with No Credit Risk
 Simulating the Future Values of Bonds with No Credit Risk
 Current and Future Values of Fixed Income Instruments: HJM Background and a Straight Bond Example
 Valuation of a Straight Bond with a Bullet Principal Payment at Maturity
 Valuing an Amortizing Loan
 Valuing RiskFree, FloatingRate Loans
 Valuing Bonds with Credit Risk
 Simulating the Future Values of Bonds with Credit Risk
 Valuing the JarrowMerton Put Option

Chapter 20: Credit Derivatives and Collateralized Debt Obligations
 Credit Default Swaps: Theory
 Credit Default Swaps: Practice
 Collateralized Debt Obligations: Theory
 Collateralized Debt Obligations: A Worked Example of Reduced Form Simulation
 Collateralized Debt Obligations: Practice
 The Copula Method of CDO Valuation: A Postmortem
 Valuing the Jarrow–Merton Put Option
 Notes

Chapter 15: An Introduction to Credit Risk

Part Four: Risk Management Applications: Instrument by Instrument
 Chapter 21: European Options on Bonds

Chapter 22: Forward and Futures Contracts
 Forward Contracts on ZeroCoupon Bonds
 Eurodollar FuturesType Forward Contracts
 Futures on ZeroCoupon Bonds: The Sydney Futures Exchange Bank Bill Contract
 Futures on CouponBearing Bonds: Dealing with the Cheapest to Deliver Option
 Eurodollar and Euroyen Futures Contracts
 Defaultable Forward and Futures Contracts
 Note
 Chapter 23: European Options on Forward and Futures Contracts
 Chapter 24: Caps and Floors
 Chapter 25: Interest Rate Swaps and Swaptions
 Chapter 26: Exotic Swap and Options Structures

Chapter 27: American Fixed Income Options
 An Overview of Numerical Techniques for Fixed Income Option Valuation
 An Example of Valuation of a Callable Bond with a ThreeFactor HJM Bushy Tree
 What is the Par Coupon on a Callable Bond?
 An Example of Valuation of a Rationally Prepaid Amortizing Loan
 Finite Difference Methods
 Binomial Lattices
 Trinomial Lattices
 HJM Valuation of American Fixed Income Options When Default Risk is Present
 Notes
 Chapter 28: Irrational Exercise of Fixed Income Options

Chapter 29: MortgageBacked Securities and AssetBacked Securities
 Transactions Costs, Prepayments, Default, and Multinomial Logit
 Legacy Prepayment Analysis of MortgageBacked Securities
 Legacy Approaches: OptionAdjusted Spread
 Implications for OAV Spread, CMOs, and ARMs
 Logistic Regression, Credit Risk, and Prepayment
 MortgageServicing Rights: The Ultimate Structured Product
 An Introduction to the Valuation of MortgageServicing Rights
 Comparing Best Practice and Common Practice in Valuing and Hedging MortgageServicing Rights
 Conclusion
 Notes
 Chapter 30: Nonmaturity Deposits

Chapter 31: Foreign Exchange Markets
 Setting the Stage: Assumptions for the Domestic and Foreign Economies
 Foreign Exchange Forwards
 Numerical Methods for Valuation of Foreign Currency Derivatives
 Legacy Approaches to Foreign Exchange Options Valuation
 Implications of a Term Structure ModelBased FX Options Formula
 The Impact of Credit Risk on Foreign Exchange Risk Formulas
 Notes
 Chapter 32: Impact of Collateral on Valuation Models
 Chapter 33: Pricing and Valuing Revolving Credit and Other Facilities
 Chapter 34: Modeling Common Stock and Convertible Bonds on a DefaultAdjusted Basis
 Chapter 35: Valuing Insurance Policies and Pension Obligations

Part Five: Portfolio Strategy and Risk Management

Chapter 36: ValueatRisk and Risk Management Objectives Revisited at the Portfolio and Company Level
 The JarrowMerton Put Option as a Measure of Total Risk: An Example
 A FourQuestion Pass–Fail Test for Financial Institutions’ CEOs and Boards of Directors
 Is Your ValueatRisk from ValueatRisk?
 VaR vs. the Put Option for Capital Allocation
 Why Are the VaR and Put Approaches So Different: SelfInsurance vs. ThirdParty Insurance
 Calculating the JarrowMerton Put Option Value and Answering the Key 4 + 26 Questions
 Valuing and Simulating the JarrowMerton Put Option
 What’s the Hedge?
 Liquidity, Performance, Capital Allocation, and Own Default Risk
 Note
 Chapter 37: Liquidity Analysis and Management

Chapter 38: Performance Measurement
 TransactionLevel Performance Measurement vs. PortfolioLevel Performance Measurement
 Plus Alpha Benchmark Performance vs. Transfer Pricing
 Why Default Risk Is Critical in Performance Measurement of Equity Portfolios
 “Plus Alpha” Performance Measurement in Insurance and Banking
 Decomposing the Reasons for Plus or Minus Alpha in a Fixed Income Portfolio
 A Worked Example of Modern Fixed Income Performance Attribution
 The JarrowMerton Put Option and Capital
 Using the JarrowMerton Put Option for Capital Allocation
 Summing Up
 Notes
 Chapter 39: Managing Institutional Default Risk and Safety and Soundness
 Chapter 40: Information Technology Considerations

Chapter 41: Shareholder Value Creation and Destruction
 Do No Harm
 Measure the Need to Change
 Rating Your Primary Risk System
 Master the Politics and Exposition of Risk Management: Shareholder Value Creation
 Daily Management Reporting of Total Risk
 Moving from Common Practice to Best Practice
 The Senior Management Perspective
 The Middle Management Perspective
 The WorkingLevel Perspective
 Getting Help to Create Shareholder Value
 Postscript
 Notes

Chapter 36: ValueatRisk and Risk Management Objectives Revisited at the Portfolio and Company Level
 Bibliography
 Index
Product Information
 Title: Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management, 2nd Edition
 Author(s):
 Release date: April 2013
 Publisher(s): Wiley
 ISBN: 9781118278550